A New Money Market Fund Model

A paper published by the European Central Bank suggests how fund managers could avoid another run on the money markets.

Companies supplying money market funds could help prevent
the fragility of the sector that caused many to “break the buck” in 2007, according
to a paper published by the European Central Bank (ECB).

In the paper, Cecilia Parlatore, an assistant professor of finance
at Wharton
School of the University of Pennsylvania, set out her new model, which she
claimed could help asset managers, investors, and the sector more generally as
it comes under greater regulatory scrutiny.

“One of the main ways to achieve the stability of the NAV is through sponsor support.” —Cecilia ParlatoreFirst, she showed how with more than $2.6 trillion in the US
and €1 trillion in European assets, the sector was an important part of the
financial landscape in terms of supplying liquidity. She outlined how both US
and European regulators were considering new legislation on the sector—and how
it was been opposed by providers.

Each regulatory system is proposing to create an alternative
to a stable net asset value (NAV), which would avoid funds having to liquidate assets
in the event of “breaking the buck”.

“These proposed regulations aim to make money market funds more
similar to other financial intermediaries: more like regular mutual funds in
the case of adopting a floating NAV and more like banks in the case of a
capital buffer,” said Parlatore.

One of the main features of these funds—maintaining a stable
$1 NAV—is the point Parlatore called in to question. She said this practice
generates costs both to investors and to the company that sponsors the fund.

“To prevent this costly liquidation, sponsors can offer
support to their funds to keep the share value at $1,” the paper said. “In
fact, one of the main ways to achieve the stability of the NAV is through
sponsor support.”

Parlatore explained how the current self-fulfilling nature
of runs on money market funds made them more likely to get into trouble again.

“If the sponsor of a money market fund expects these asset
prices, and thus the NAV, to be low, he will also expect a high cost of offering
support, and may choose not to keep the fund open, and sell all the fund’s
assets,” she said. “If all sponsors share these beliefs, the demand for assets
will be low, the NAV will be low, and the money market fund industry will
experience large outflows due to the liquidation of the funds.”

These large outflows can be thought of as a run of the funds
on the money market itself, Parlatore said, indicating the potential impact of
such a huge part of the industry.

However, her solution was to turn the above scenario on its
head.

“On the other hand, if a sponsor expects the NAV to be high,
he has incentives to offer support and keep the fund open. If all sponsors
behave in this way, the need for support will be lower and the funds will
remain open. By preventing the liquidation of a fund, sponsor support keeps the
demand for assets high, and, through the calculation of the NAV, decreases other
sponsors’ need to offer support.”